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Is It Safe To Buy These High-Yield Stocks?

For any investors in search of yield, May 21, 2013, will be
remembered for a long time to come.

That's the day that Federal Reserve released the minutes from
a prior meeting, suggesting that the multi-year massive stimulus
program known as quantitative easing would start to wind down.
Though the Fed wouldn't actually take such action for a few more
quarters, the psychological blow against dividend-paying stocks
had begun. Competing fixed-income investments began to rise,
leading yield-producing stocks to be among the worst performers
of the rest of 2013.

#-ad_banner-#Perhaps no group took it quite as hard as the
mortgage REITs (also known as mREITs). These firms had been
making a killing on the wide spreads between low short-term rates
and higher mortgage rates. And as interest rates begin to move
higher, the profit margins at these firms may compress.

For investors, there are two important questions to consider:
Are these companies still capable of solid profits in the years
ahead? And is it wise to wait the two to three years before the
rising rate cycle has fully played out before they become safe to
buy?

The Road Ahead
Make no mistake, the mREITs would be hurting even if rates
weren't rising. In July 2013, financial regulators proposed that
banks hold on to more of their assets as they adhere to a
supplementary leverage ratio
(SLR).

Historically, mREITs have profited from the vast sums of
mortgage bonds that banks have traditionally packaged and sold
off. That market won't be drying up, but it will be shrinking as
banks hold more mortgages on their books.

Though many mREITs now sport double-digit dividend yields
after falling in value in 2013, Merrill's analysts think they may
be value traps: "The potential for capital losses make them less
attractive," note the analysts.

Analysts at Merrill Lynch predict two results from these new
rules: "1) Lower demand for Treasurys and agencies, and 2)
adverse effects on liquidity, transaction costs and trading
volumes in these markets."

These analysts suggest that yield-seeking investors stick with
mREITs that focus on the commercial sector, and not the
residential sector, as sensitivity to interest rates and
regulatory changes are not as great. They are a fan of
Starwood Property Trust (NYSE:
STWD
)
,
Apollo Commercial Real Estate Finance (NYSE:
ARI
)
and
Ares Commercial Real Estate Corp. (Nasdaq:
ACRE
)
. ARI, with a 9.6% dividend yield, is the highest yielder in this
group, while ACRE is the only one with upside (15%) relative to
Merrill's target prices.

But there is one residential-focused mREIT that stands out
from the crowd, and to see why, you need to know the difference
between agency REITs and non-agency REITs. The former buys
mortgages from federal agencies such as
Fannie Mae (
FNMA
)
, and these mortgages tend to carry low mortgage rates. That's
why buyers of these mortgages, such as
Annaly Capital (NYSE:
NLY
)
, tend to deploy a lot of debt to goose their returns. More
importantly, rising interest rates may eventually eliminate the
spreads these firms typically enjoy, as Fannie Mae-backed
mortgage rates will rise in tandem with the 10-year Treasury.

Non-agency REITs, on the other hand, buy mortgages issued by
banks and other lenders and don't have nearly the same degree of
interest rate exposure. These kinds of mortgages are riskier in a
bad economy, as we saw in 2008 and 2009, but are both safer and
more appealing (thanks to those higher yields) in a firming
economy. For example, rising home prices have sharply cut the
amount of mortgages that are "underwater," which boosts the value
of existing mortgages as the chances of default are now rapidly
shrinking.

Two Harbors Investment (NYSE:
TWO
)
, with some exposure to the non-agency market simply doesn't have
the full interest rate risk that mREITs such as Annaly do.
Moreover, shares represent both solid value (5% discount to
tangible book) and a solid 10.6% dividend yield.

Two Harbors acknowledges that investors are anxious about how
it will fare in an environment of rising rates. Not only has the
company been boosting its exposure to the on-agency market, but
it is also expanding into a segment known as
mortgage servicing rights
(MSRs). In effect, Two Harbors is moving beyond bond investing
and into a fee-based business.

MSRs are what they sound like: They have control over mortgage
processing, an area in which the banks are looking to shed
exposure. Merrill Lynch is a fan of the move: "We believe MSRs
are an attractive investment class for TWO due to the
seller/purchaser mismatch in the space and the asset's negative
correlation to rates, suggesting they could contribute to
earnings per share and book value stability going forward."

Risks to Consider:
The biggest risk for mREITs will always be the housing
market. If the economy slowed and housing took a fresh hit, the
value of bonds held by REITs would fall in value, due to a
perceived higher risk of default. That said, few expect the
housing market to weaken in 2014.

Action to Take -->
The rising rate environment has hurt many high-yield stocks. In
response to a question I posed earlier, investors do not need for
rates to peak before buying such stocks. The double-digit yields
now in place appear to already reflect the challenges to come
from higher rates, and in some cases, these stock will post solid
rallies as the impact of rising rates proves to be less painful
than some fear.

Yet it's crucial that you understand how these companies are
positioned, which kinds of bonds they own, and what higher rates
will mean for their income production. In the case of Two
Harbors, the outlook for continued solid profit margins remains
in place.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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